Bond
Bond Portfolio
Portfolio Management
Management Strategies
Strategies

–Performance, Style, and Strategy

–Passive Management Strategies
–Active Management Strategies
–Core-Plus Management Strategies
–Matched-Funding Strategies
–Contingent and Structured Strategies
 Bond Portfolio Performance
Style and Strategy
• Bond Portfolio Performance
– Fixed-income portfolios generally produce both less
return and less volatility than found in other asset
classes (e.g., domestic equity, foreign equity)
– shows this in the examination of the investment
performance of different long-term securities over
the 21-year time horizon
– The low historical correlation between fixed-income
and equity securities—Reilly and Wright (2004)
calculated this to be 0.27—has made bond
portfolios an excellent tool for diversifying risk

19-2
 Bond Portfolio Performance
Style and Strategy
• Bond Portfolio Style
– The investment style of a bond portfolio can be
summarized by its two most important
characteristics: credit quality and interest rate
sensitivity
– The average credit quality of the portfolio can be
classified as high, medium, and low grades
– The interest rate sensitivity of the bond portfolio can
be separated as short-term, intermediate-term, and
long-term

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 Bond Portfolio Performance
Style and Strategy
• Bond Portfolio Strategies
– Passive Portfolio Strategies
– Active Management Strategies
– Core-plus Management Strategy
– Matched-funding Techniques
– Contingent Procedure (Structured Active
Management)

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 Passive Portfolio Strategies
• Buy and hold
– A manager selects a portfolio of bonds based on
the objectives and constraints of the client with the
intent of holding these bonds to maturity
– Can by modified by trading into more desirable
positions
• Indexing
– The objective is to construct a portfolio of bonds
that will track the performance of a bond index
– Performance analysis involves examining tracking
error for differences between portfolio performance
and index performance

19-7
 Active Management Strategies
• Active management strategies attempt to
beat the market
• Mostly the success or failure is going to come
from the ability to accurately forecast future
interest rates
• Active Strategy Attributes
– Scalability
– Sustainability
– Risk-adjusted performance
– Extreme values

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 Active Management Strategies
• Interest-rate anticipation
– Risky strategy relying on uncertain forecasts
– Ladder strategy staggers maturities
– Barbell strategy splits funds between short duration
and long duration securities
• Valuation analysis
– The portfolio manager attempts to select bonds
based on their intrinsic value
• Credit analysis
– Involves detailed analysis of the bond issuer to
determine expected changes in its default risk
– See Exhibit 19.6
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 Exhibit 19.6

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 Active Management Strategies
• High-Yield Bond Research
– Several investment houses such as Merrill Lynch,
First Boston, Lehman Brothers, etc., have developed
specialized high-yield groups that examine high-yield
bond issues and monitor high-yield bond spreads
• Yield spread analysis
– Assumes normal relationships exist between the
yields for bonds in alternative sectors
• Bond swaps
– Involve liquidating a current position and
simultaneously buying a different issue in its place
with similar attributes but having a chance for
improved return
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 Active Management Strategies
• Bond Swaps Types
– Pure yield pickup swap
• Swapping low-coupon bonds into higher coupon
bonds
– Substitution swap
• Swapping a seemingly identical bond for one that is
currently thought to be undervalued
– Tax swap
• Swap in order to manage tax liability (taxable & munis)
– Swap strategies and market-efficiency
• Bond swaps by their nature suggest market
inefficiency
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 Active Global Bond Investing
• An active approach to global fixed-income
management must consider the following
three interrelated factors
– The local economy in each country including the
effects of domestic and international demand
– The impact of total demand and domestic
monetary policy on inflation and interest rates
– The effect of the economy, inflation, and interest
rates on the exchange rates among countries

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 Core-Plus Management Strategies
• A combination of passive and active styles ( a
form of enhanced indexing)
• A large, significant part of the portfolio is
passively managed in one of two sectors:
– The U.S. aggregate sector, which includes
mortgage-backed and asset-backed securities
– The U.S. Government/Corporate sector alone
• The rest of the portfolio is actively managed
– Often focused on high yield bonds, foreign bonds,
emerging market debt
– Diversification effects help to manage risks
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 Matched-Funding Strategies
• Dedicated Portfolios
– Designing portfolios that will service liabilities
– Exact cash match
• Conservative strategy, matching portfolio cash flows
to needs for cash
• Useful for sinking funds and maturing principal
payments
– Dedication with reinvestment
• Does not require exact cash flow match with liability
stream
• Great choices, flexibility can aid in generating higher
returns with lower costs

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 Matched-Funding Techniques
• Immunization Strategies
– The process is intended to eliminate interest rate
risk that includes:
• Price Risk
• Coupon Reinvestment Risk
– A portfolio manager (after client consultation) may
decide that the optimal strategy is to immunize the
portfolio from interest rate changes
– The immunization techniques attempt to derive a
specified rate of return during a given investment
horizon regardless of what happens to market
interest rates
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 Matched-Funding Techniques
• Classical Immunization
– Immunize a portfolio from interest rate risk by
keeping the portfolio duration equal to the
investment horizon
– Duration strategy superior to a strategy based only
a maturity since duration considers both sources of
interest rate risk
– An immunized portfolio requires frequent
rebalancing because the modified duration of the
portfolio always should be equal to the remaining
time horizon

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 Matched-Funding Techniques
• Difficulties in Maintaining Immunization
Strategy
– Rebalancing required as duration declines more
slowly than term to maturity
– Modified duration changes with a change in market
interest rates
– Yield curves shift

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 Matched-Funding Techniques
• Horizon matching
– Combination of cash-matching dedication and
immunization
– Important decision is the length of the horizon
period
– With multiple cash needs over specified time
periods, can duration-match for the time periods,
while cash-matching within each time period
– See Exhibit 19.17

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 Contingent and Structured Strategies
• Contingent procedures for managing bond
portfolios are a form of what has come to be
called structured active management
• Contingent Immunization
– Duration of portfolio must be maintained at the
horizon value
– Cushion spread is potential return below the
current market return
– Safety margin is a portfolio value above the
required value
– Trigger point refers to the minimum return that will
stop active portfolio management
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